How JPMorgan drew regulators' ire in California power market

July 22 (Reuters) - The California electricity trades that may bring JPMorgan Chase & Co a record penalty stem from a “flaw” in the regional trading system, highlighting why power traders are increasingly anxious about a broad crackdown on the market.

The Wall Street bank is working to close the book on an investigation that dates back more than two years, when the California Independent System Operator (ISO), the state’s grid operator, noticed that a then-unnamed market participant had been using an “exploitative” trading strategy that had effectively forced the grid to pay for a plant to sit idle, ultimately adding to customers’ costs.

JPMorgan initially denied the accusations but is now reportedly in talks with the U.S. Federal Energy Regulatory Commission (FERC) to settle the complaint for hundreds of millions of dollars, a potentially record penalty for the agency.

The case comes amid a series of high-profile investigations by FERC, which in 2005 was granted by Congress expanded powers to pursue market malfeasance in the wake of the Enron scandal and the 2000-2001 California energy debacle. FERC levied $470 million in penalties against Barclays PLC this week for manipulating California power markets.

But unlike traders’ brazen efforts to choke off power supplies and jack up rates for “Grandma Millie” a decade ago, the recent activities stem from far more subtle gambits in which traders may benefit whether prices go up or down.

The deeper focus on what appear to be less overt forms of manipulation - or what some players would more likely deem entrepreneurial trading - has sent shivers through the industry, forcing companies to reassess the risk of participating in the $200 billion U.S. physical power market.

“FERC is trying to convey where it views market activity that might otherwise be permitted under the letter of the market regulations to nonetheless be considered unlawful and, in FERC’s view, manipulation,” said David Doot, a partner who covers energy at law firm Day Pitney, told Reuters.

“Clients are revisiting what they are doing to make sure (they) are OK and not skating too close to the line.”

During a four-month period from March through June 2011, the operators of the California and Midwest power grids - the California ISO and Midwest ISO - made four different filings to FERC to close market loopholes and alert regulators of the bank’s “abusive” bidding strategies. (ISOs are nonprofit public entities responsible for operating power grids and running competitive power markets.)

The ISOs estimated three of the bidding techniques together resulted in at least $73 million in improper payments, not including “millions of dollars in payments from another technique,” according to a FERC lawsuit.

CLOSING LOOPHOLES

In a series of filings over the past two years, the California ISO described what it called “exploitative bidding practices” that amounted to bait-and-switch maneuvers.

The ISO said JPMorgan “aggravated the market impact of (a) flaw” of the “bid cost recovery” mechanism, which assures generators will receive compensation for their power plant’s fixed startup and operating costs if the ISO asks their unit to run but it fails to cover its costs from power sales.

The ISO also accused the bank of causing the misuse of “exceptional dispatch,” which is a system to activate power plants on a last-minute basis as necessary to prevent unexpected emergencies that could threaten grid reliability.

FERC approved each of the ISOs’ requests to change their market rules and prevent further abuses.

JPMorgan’s trading practices are outlined in the California ISO’s filings with FERC dating to March 2011, when it asked the regulator to modify market rules that had been put in place in April 2009, when the grid launched a new trading system.

That month the ISO told JPMorgan it was notifying FERC’s Office of Enforcement of the bank’s exploitative bidding practices. But JPMorgan was not publicly identified as the trader in question until FERC subpoenaed the bank in July 2012 to provide emails related to an investigation into market manipulation in California and the Midwest.

FERC closed the bid-cost-recovery loophole in May 2011 and the exceptional-dispatch loophole in August 2011.

For a time line of FERC’s investigation of JPMorgan, see:

FERC’s outgoing chairman, Jon Wellinghoff, has said the newly empowered enforcement team is targeting malfeasance, not Wall Street, but traders still fear that its action could reduce liquidity in the market, making prices more volatile.

“FERC likes having financial players in the markets because they add capital and liquidity,” said Marc Spitzer, a former commissioner at FERC from 2006-2011 and currently a partner at Washington law firm Steptoe & Johnson.

“But, we don’t want them to manipulate an arguable gap in the law that they managed to find.”

HOW THE BANK DID IT

The bank’s trading activities in California revolved largely around operations at a handful of power plants that JPMorgan effectively operated under “tolling” arrangements. The plants were owned by AES Corp, but JPMorgan was responsible for fuel-supply and power sales.

Under such agreements, the plant owner (AES) still operates the facility, but the third party (JPMorgan) has a significant amount of control over how and when the plant runs, based on its contract and the profitability of its trades.

According to the California grid, JPMorgan took advantage of a dynamic that is peculiar to physical power markets, which operate on two different time frames: next-day and real-time.

In the so-called day-ahead market, the grid solicits offers to sell electricity for the coming day based on forecast demand and other factors. The California ISO selects which power plants will run based on competitive bids from generators.

Because capacity needs can vary widely depending on weather conditions, the day of the week and other factors, the grid also operates a real-time market, where spot prices and real conditions require the grid to balance supply and demand on an hourly basis. Prices can fluctuate wildly in this market, spiking three- or fourfold in an hour if the grid is short.

The day-ahead bids include not only the price at which the plant will sell electricity but also the startup costs and minimum load costs it will incur. By selecting a plant to run, the grid agrees to pay those fixed costs if the plant is underutilized because, for example, electricity demand is lower.

The costs, which include fuel and other expenses, are repaid only if the plant can’t recover them through regular sales. They are not disclosed for competitive reasons.

It is this minimum cost that JPMorgan is said to have exploited to its own advantage. The ISO did not say how much the bank reaped from this kind of trade, but the grid operator has already recovered $52 million from power sellers due to such deals.

JPMorgan’s trading strategy, the ISO said, was to submit bids with high minimum load costs but exceptionally low - sometimes negative - power prices, making them attractive enough for the grid to schedule the plant to run the next day.

But in the following day’s real-time market, JPMorgan would change its prices, submitting very high bids that discouraged the grid from “dispatching,” or running, the plants.

That would leave the unit running below its minimum level or not at all, triggering a “minimum load” payment to cover those costs.

To cover the previous day’s sales, JPMorgan traders would simply buy power supplies in the spot market - potentially making a loss on the electricity trades themselves but more than making up the difference when the grid paid to cover the fixed startup and minimum load costs.

The ISO said the problem started in December 2010 when bid-cost-recovery “uplift” charges reached $16 million, up from previous monthly payments of $5 million to $11 million. In January 2011 the ISO said uplift amounts surpassed $20 million.

EXCEPTIONAL DISPATCH

The grid also said the bid-cost-recovery strategy increased power costs by causing it to call on emergency reserve generation under the “exceptional dispatch” system because some plants were not meeting their day-ahead commitments.

In the day-ahead market, the ISO selects the units that will produce energy as well as those that will be held in reserve. Reserve units, which typically represent up to 7 percent of forecast daily demand, stand ready to operate in case of an unexpected shutdown or surge in demand.

By removing its units from the real-time market, JPMorgan’s bidding strategy in some cases also removed units from the pool of reserve capacity, which sometimes forced the ISO to dispatch other units to maintain required reserves at much higher prices.

The ISO said in just five days in April 2011 it paid out $3.6 million in exceptional-dispatch payments related to the bidding strategies. It did not say who profited from these payments.

In May, JPMorgan sold the tolling agreements for three AES plants to California power company Southern California Edison, a unit of Edison International.